A Cycle to Watch Out For

Perhaps we’re back to our old ways. For many moons, the household savings rate has again been falling, though it is still above the levels reached in the years leading up to the home loan crisis of 2007–2009. There are even some signs of a resurgence of the mortgage-backed securities industry. Could the economy be riding a merry-go-round familiar to students of economic history, as concerns about financial fragility, risky borrowing, and small nest eggs ebb and flow with the headlines of the day?

There is an economic term for this type of historical pattern that has not been prominent in recent debates. In loose terms, an epistemic cycle is an economic cycle of learning, knowing about, or understanding certain issues or facts; for example, the dangers of reckless consumer borrowing. The late Hyman Minsky of our Institute wrote authoritatively about the tendency of financial risk-taking to build up over time in the years following a crisis, as people gradually let their guard down after a fight to save the financial system. Eventually such trends would bring on a crisis and a subsequent return to more cautious behavior, especially on the part of banks and regulators.

This leads to the question of whether policymakers can reduce the danger that risky levels and types of borrowing will return over the coming years, as people begin to put the financial turmoil of the past few years into perspective. Economists of all stripes tend to be pessimistic about such issues, ironically in many cases because of a belief that human behavior is generally rational in one way or another.

One concept that often comes up in discussions of policies for dealing with the aftermath of the crisis is moral hazard, which was the subject of an interesting essay in yesterday’s New York Times. In the context of finance, this is the risk that bankers, borrowers, etc. will not fulfill their responsibilities because they know that losses that they incur will be covered by insurance, bailouts, and the like. As the Times notes, many have argued against further government assistance for the financial industry or for financially stressed homeowners on the grounds that such programs could exacerbate the moral hazard problem, i.e., that people and corporations might take advantage of forgiveness.

But how about policies designed to reduce the frequency of situations in which the government and the people are in the position of having decide whether to forgive? For example, the Dodd-Frank financial legislation of 2010 was intended in part to strengthen rules against conduct and practices that allowed and in some cases encouraged consumers to get too far into debt. The country might do well to use this opportunity to work in advance to discourage people from acting on their more reckless tendencies and impulses when they make financial decisions.

As an example of the issues at stake, many recall concerns about the aggressive marketing of credit cards to students, unrealistically low minimum monthly payments, and the like. The rules involved are among the institutions that have shaped economic behavior, contributing for example to high rates of bankruptcy and low savings rates in the United States compared to other countries.  (“Medical bankruptcies,” and similar phenomena, as well as fraud, are of course also crucial.) The academic literature indicates that rules about consumer lending often have a big impact on borrowing decisions. Some excellent coverage of these issues is available at the Credit Slips blog, and, of course, these Ford-Levy projects have been working on financial re-regulation issues in general. Senior Scholar Ed Wolff documented the seriousness of ongoing problems with the distribution and level of household savings and debt in this working paper last fall.

The details of many of the new rules are still being worked out by various regulatory agencies. (For some recent news on overdraft fee regulation, see this NYT editorial.) Further legislation is inevitable, while, on the other hand, some in Congress seek to repeal Dodd-Frank altogether. This is a key area of policy concern for people worried about macroeconomic and financial stability. Work and discussion along these lines would hopefully be less divisive than emphasizing questions about who should pay the costs associated with the bad loans of, say, 2000 to 2006, when checks on excessive or unwise lending had already become very lax.

Perhaps the cycle of financial folly can be tamed to a great degree with some careful analysis and legislation.